Japan’s new code puts LPs’ focus on ESG

It is now 12 months since the second revision of Japan’s Stewardship Code was released by the Japan Financial Services Agency. The code, originally introduced in 2014, sets out the stewardship responsibilities of institutional investors, namely their responsibilities to enhance the medium- to long-term investment return for their clients and beneficiaries by improving and fostering the investee companies’ corporate value and sustainable growth. Before the 2020 revision, the code did not specifically refer to intersections between ESG issues and investee companies’ sustainable growth and how institutional investors should address such ESG issues in dialogues or other engagement activities with investee companies, as well as in their investment management strategies and policies.

Given increasing recognition that ESG can have a significant impact on business value, the 2020 revision requires, among other things, institutional investors to: (i) clarify their approach to sustainability issues (including ESG issues) in their stewardship policies; (ii) apply such an approach to their constructive engagement with investee companies in accordance with their investment management strategies; and (iii) develop skills and resources to evaluate sustainability issues to appropriately engage with investee companies.

The 2020 revision also further clarifies stewardship responsibilities of asset owners and encourages greater engagement by corporate pension funds in promoting and monitoring stewardship by themselves or through asset managers based on their size and capabilities.

Indirect impact

While the 2020 revision is expected to serve as a new benchmark for institutional investors to fulfil ESG responsibilities and accelerate integration of ESG issues into their policy, what impact should the Japanese PE industry expect from it? Although there had been a debate as to whether the scope of the code’s application should be extended to non-listed shares, the FSA maintained its position that the code still basically applies to investment in Japanese listed shares, noting institutional investors may voluntarily apply their stewardship responsibilities to other asset classes.

Therefore, its impact on the Japanese PE industry may be indirect. However, the general increase in engagement in ESG by Japanese institutional investors would inevitably require Japanese PE firms to install a higher level of ESG integration in their investment process, and more extensive due diligence on ESG policies and reporting would be requested by domestic LP investors.

While it becomes more common for major Japanese PE firms (especially those with foreign LP investors) to sign up to an independent industry-recognised standard, such as the Principles for Responsible Investment, to accommodate increasing expectations from LPs regarding ESG issues, ESG is not yet recognised as a predominant value in Japanese PE as compared to Western countries. Highlighting ESG issues in the 2020 revision will likely see greater scrutiny on the selection of PE funds by Japanese institutional investors in terms of ESG. Further, it will become more important for Japanese firms to establish compelling ESG policies and demonstrate effective management of ESG issues in their activities to survive in a globally competitive market.

Tetsuo Tsujimoto is a partner in Baker McKenzie’s Tokyo office